Market Memo: So far, OPEC's 'grand bargain' is grand ... for U.S. shale

01-19-2017

Portfolio Manager Lila Manassa Murphy attended last week’s Atlantic Council Global Energy Forum in Abu Dhabi, United Arab Emirates—an event of historical significance as it was the first major gathering of OPEC ministers following November’s so-called “grand bargain” to cut production and support higher oil prices.She shares her three main takeaways.

Iraq represents risk to the agreement. In general, the tone was very collaborative and supportive of the Nov. 30 agreement. Saudi Oil Minister Khalid al-Falih highlighted his confidence in OPEC’s ability to balance the global oil markets and stabilize pricing along with many non-OPEC members. While not giving a specific price target, they believe today’s pricing is unsustainable as the industry is underinvesting in its longer-term future. This is why the tone from Iraq Oil Minister Jabbar Ali Hussein Al-Luiebi was of particular interest. It was in stark contrast to the conciliatory tone emanating from all other oil ministers. He felt Iraq’s share of production cuts was too high and that Iraq should have been exempted entirely from cuts.

It comes down to compliance.What happens next will be key as, unfortunately, noncompliance has consistently been the case when we look back upon prior OPEC agreements. Agreements typically have started out strong, with oil ministers confident in their ability to manage their market. Invariably, someone becomes disgruntled and breaks compliance. While most OPEC ministers spoke of their trust in OPEC’s commitment and its compliance mechanism led by the Kuwaiti ministry, it was clear the details of how the new mechanism will be managed have not quite been fully hashed out. We should see more detail about this in the weeks ahead, but in order to have credibility, there must be some strong disincentive to cheating. When asked if OPEC was willing to take additional cuts to ensure the cap on production is met, particularly given the Iraqi minister’s comments, the tone was definitely that of wait-and-see.

U.S. shale’s impact is underestimated. Iraq’s was the only oil minister to address the dilemma of U.S. shale head on, expressing a very legitimate concern that any pricing increase will be reflected directly in investment in U.S. shale. Otherwise, there was very little discussion about what to me was the elephant in the room. Arguably, the most significant issue to arise from the meeting was the seeming unwillingness of OPEC to talk about U.S. shale. The reality is if total U.S. production were to return to the old highs of 9.6 million barrels per day, it would be equivalent to the second-largest OPEC producer. Although the forum opened with an acknowledgement that shale is gaining ground, given how fragile and reactionary the market is to any new data point reflecting supply growth (i.e., Libya indicating production increases, rising rig counts, etc.), it was surprising shale was MIA. When asked about shale directly, a few of the ministers actually expressed a desire for American companies to join OPEC!

In general, there were few contrarian voices about the “grand bargain” and not a lot of buy-in on the sustainability of all the efficiency gains U.S. shale has made over the last two years. While I subscribe to the view that U.S. shale service providers may raise prices as the rig count climbs, potentially affecting breakeven price levels, I also think a significant portion of productivity gains are built in. So to me, a key and still unaddressed question is this: will OPEC allow the U.S. to take market share if oil stays $50-60 a barrel, a level that has U.S. producers taking on more rigs? So far, the answer appears to be yes, but I question how long this can continue before frustration on the part of OPEC countries emerges, a taste of which we got from the Iraqi minister’s comments. For now, the grand bargain is a clear win for the American shale oil revolution.